THE NET INTEREST INCOME CONUNDRUM: SURVIVE OR THRIVE

By Ewen Fleming, Partner, Financial Services Advisory (Banking), Grant Thornton UK LLP.

What can banks and building societies do to deliver high savings rates while still meeting their conduct obligations, and is it fair to accuse them of giving customers a raw deal?

Context:

Savers have been dealt another blow as inflation has dropped to record lows of 0.3% in early 2015.[1] Falling prices of food and fuel have been the main drivers, although we have also seen the Retail Prices Index (RPI) dropping to 1.1%, adding to the downward pressure on inflation. This is generally considered good news for consumers and the value of their money; however it will likely translate into further pressure on savers who are generating low returns from their nest eggs.

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In January the FCA came out saying that savers are “getting a raw deal” and have been let down by the High Street Banks.

In particular, the FCA found around £160bn of the funds held in easy access savings accounts earned an interest rate equal to or lower than the Bank of England base rate of 0.5% in 2013, yet consumers often find it difficult to know what rate they are on, or are put off switching by the expected inconvenience. 80% of easy access accounts have not been switched in the last three years.[2]

In the context of ongoing reputational issues faced by financial institutions, brought on by high profile cases of misconduct and unethical behaviour; the public may find it is easy to pin low savings rates as the fault of the banks. But are they being unfairly criticised?Is it within their gift to increase rates given the economy they are operating in and the regulatory obligations they are expected to adhere to?

Banks often come under fire for driving profit and the public is quick to villainise banks for appearing to rake in profits while the rest of the economy struggles to recover[3]. In reality a strong and stable financial sector benefits the wider economy in a number of ways: financial institutions need to be able to attract investors and then reward those shareholders for their investment and the government needs a profitable financial sector for a healthy economy.

Banks making sustainable profits while serving their customers with the advice and products they need is a good thing although that balance is becoming harder to achieve.

A Challenging Economic and Regulatory Environment

The official bank rate has been at an unprecedented low of 0.5% since 2009.Consumer confidence is only slowly improving [4] and the improved employment figures have not yet translated into economic activity. Some of this be could the impact of increasing life expectancy and therefore retirement periods, forcing consumers to spend less now and save more to cushion them in later years [5]

The Government’s Funding for Lending Scheme has provided lenders with a cheap source of funding making them less reliant on savings deposits and enabling them to slash savings rates.

The FCA’ s Customer Conduct Agenda compels financial institutions to keep their  customer’s interests front of mind. They are expected to treat customers fairly, often demonstrated through helping customers understand the benefits and risks of products, providing clear information and good service. Government has added pressure by urging banks to keep the “last branch in town” open providing access to banking in rural communities.[6]

This makes for a challenging economic and regulatory environment for banks to operate in, whilst remaining profitable.

The Regulator would like to see firms focus on core banking activities and move away from complex securitisation models. The impending ring-fencing deadline will mean that retail banks will be even more dependent on traditional banking activities as their income will no longer be subsidised by their investment banking arm.

A retail bank or building society’s chief source of income is Net Interest Income (NII). In its most basic form; the differential between the rate earned on loans and the rate paid on savings. If the official rate remains at 0.5%; what levers do these organisations have available to them to improve margins and profits, improve savings rates and maintain their obligations to the customer?

Ewen Fleming
Ewen Fleming

Traditional Tools Are No Longer Effective

Differential Pricing per delivery channel

Until recently, banks were able to differentiate pricing based on the delivery channel and customers accepted the value distinction between channels. Customers who demand the security of face-to-face interactions have traditionally accepted the trade-off of earning less on savings products sold and serviced through the branch network while banks have heavily marketed “online only” deals to entice customers to purchase products via the internet.

An omni-channel world has now decoupled products and channels. A multi-tier pricing system will only serve to alienate customers who are now comfortable using more than one channel and will likely discover that they are able to get the same product at a better price had they gone online instead of walking into a branch.

Bonus rates

Although the FCA has frowned on the use of bonus or teaser rates – attractive,but temporary rates used to entice savers – they failed to ban the practice altogether. However “large back books that may lead banks to act against their existing customers” was cited as one of the seven forward looking areas of focus in the FCA 2014 Risk Outlook Statement and we expect this to be an area of high priority to the Regulator.[7]

We have already seen the Royal Bank of Scotland curtail their use of teaser rates offered with savings and credit card products. CEO Ross McEwan, is quoted as saying “You would have thought you would get a better rate for staying, rather than a worse rate for staying and a better rate for going,”[8] The removal of teaser rates and front and back book differential pricing changes the economics considerably.

Cross sales

The easiest way to generate new business and income is to offer existing customers more products. Repeat customers tend to spend more, cost less to acquire and are more loyal to the brand. Every bank competes to own as much of their customers’ wallet as possible.

The PPI mis-selling scandal has cost the industry millions and subsequent remediation and fines on PPI and other cross sold products has made firms rightfully wary of pushing products on customers who don’t understand what they are.[9] Cross selling and bundling products makes it difficult for customers to compare across competitors and allows banks to mask costs and justify lower rates of returns.

Calls for greater transparency and accountability in this area mean that financial service providers are now required to evidence that products have been sold fairly and that the product is deemed suitable for the customer’s need. This is known as an advised sales process and has made selling more complex and costly to provide and to evidence they have delivered this compliantly.

Lend more for more

The ability to increase lending rates and fund this lending with cheap savings is the most powerful lever for banks and building societies to widen the NII margin. When demand for loans is strong, backed by a growing economy, firms typically acquire new savings by offering higher rates. However many of the high street brands are finding it difficult to lend money out. Within the existing regulatory framework banks are incentivised to lend to low risk borrowers and there just aren’t as many of them out there as the banks would like to hear from.

Metro Bank is testament to that and in its financial statements to 31 December 2014 the bank reported deposits of £2,867 million compared to total loans of £1,597 million.[10] Despite the imbalance,Metro Bank deposits are still growing marginally faster than loans and this is despite a focus on lending to business customers who now make up almost half of its total lending.

Where to from here?

As discussed, banks and building societies are not in a position to easily widen the NII margin using traditional levers.

Given NII margins are being squeezed, where can these organisations compensate for the short-fall while imbibing the values encouraged by the FCA?[11]

The fee debate

The debate continues about whether or not banks should charge fees on current accounts. A fee structure will help create transparency and facilitate competition as customers would be able to compare products like for like. It seems inevitable that UK banks will eventually follow many of their international peers and introduce a fee structure for basic transactional accounts.

However the introduction of fees will cause an upset and given the current public opinion, manymay choose to tread cautiously in this area.

Change the business model

The reality that a low interest rate environment might be here to stay,[12] means that financial service providers need to abandon short term fixes to keep them afloat and rather, commit to fundamentally changing their business model.

Disruptive and innovative change is required.

One such example is committing and wholeheartedly embracing the digital agenda that so many organisations have been toying with over the last decade or more.

A digital bank; one that moves beyond digital channels and strives for a digital, integrated core will be able to realise long term cost efficiencies that will translate into operational savings and can eventually have a positive impact on rates; all the while keeping the customer at the heart of the business.

So perhaps the debate rightfully moves to cost:income ratios once more, but focused on slashing costs without sacrificing levels of service or operations. The tricky balance for organisations will be to simultaneously keep customers’ welfare at the heart of their operations, offera great customer experience and increase returns for their investors.

Many banks are standing on the edge of the proverbial “burning platform”; there has been enough debate andthe survivors will be the ones who make the decision to jump into and embrace the new world order. The ones who jump soonest and execute with excellence will be the ones that prosper.

[1]Office for national Statistics http://ons.gov.uk/ons/rel/cpi/consumer-price-indices/january-2015/consumer-price-inflation-summary–january-2015.html

[2]  Consumers with cash savings need better information and easier switching. http://www.fca.org.uk/news/consumers-with-cash-savings-need-better-information

[3] http://www.forbes.com/sites/halahtouryalai/2012/08/28/what-downturn-bank-profits-hit-34-5-billion/

[4] http://www.gfk.com/uk/news-and-events/press-room/press-releases/pages/january-sees-a-five-point-increase-in-consumer-confidence-levels-.aspx

[5]Andy Haldane; Bank of England Chief Economist. http://www.telegraph.co.uk/finance/personalfinance/interest-rates/11251615/Workers-saving-for-retirement-keeping-interest-rates-low.html

[6] http://www.thisismoney.co.uk/money/saving/article-2934410/Pressure-mounts-stop-banks-deserting-communities-closing-branches-town.html

[7]FCA 2014 Risk Outlook Statement. http://www.fca.org.uk/your-fca/documents/corporate/fca-risk-outlook-2014

[8]FT.com Monday interview: Ross McEwan, Royal Bank of Scotland. http://www.ft.com/cms/s/0/1605e4b8-ad40-11e4-a5c1-00144feab7de.html#axzz3S77nVjG8

[9] http://www.theguardian.com/money/2011/apr/20/fsa-wins-ppi-battle-banks

[10] https://www.metrobankonline.co.uk/News-Events/PressReleases/2015/January/Metro-Bank-grows-118-in-2014/article/

[11] http://www.fca.org.uk/static/documents/fca-approach-advancing-objectives.pdf

[12] http://www.thisismoney.co.uk/money/news/article-1607881/When-UK-rates-rise.html

[13] http://www.bankofengland.co.uk/boeapps/iadb/Repo.asp

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